Which investment strategy can ETFs use for index replication?

The correct answer is the engagement in derivatives, as this method is a widely utilized strategy by ETFs for index replication. When an ETF aims to track the performance of a specific index, it may not always be feasible or efficient to purchase every single security in the index, especially if the index includes a large number of stocks or other assets. Instead, ETFs can use derivatives such as futures contracts, options, and swaps. These financial instruments can provide exposure to the movements of the underlying index without requiring the actual purchase of each component. This strategy helps in achieving close tracking of the index performance while potentially reducing transaction costs.

By using derivatives, ETFs are able to manage liquidity and enhance their ability to replicate the index's performance effectively, even in situations where direct investment in the underlying securities may not be as practical. This flexibility is one of the integral advantages of ETFs in managing index funds and allows them to tailor their investment approach to better suit market conditions and liquidity needs.